SAN FRANCISCO — Experts say a federal court ruling that may allow Vallejo, Calif., to escape its labor contracts could make bankruptcy a much more tempting option for municipalities and is likely to be upheld by higher courts.

U.S. Bankruptcy Court Judge Michael McManus said in a legal memorandum last week that Chapter 9 of the U.S. bankruptcy code allows municipalities to reject collective bargaining agreements. McManus stopped short of actually rejecting Vallejo’s contracts, telling the city and its unions to make a final attempt at negotiation before he decides the matter finally.

McManus’ memo on the law “will certainly make Chapter 9 a more attractive option for municipalities struggling with labor costs,” said William W. Kannel, a bankruptcy lawyer with Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC in Boston.

Last May, Vallejo filed the largest municipal bankruptcy since Orange County’s 1994 bankruptcy. The city claimed that a slowing economy and declining revenues meant that it could no longer afford generous pay and benefits it had promised to public employees. It has since negotiated steep cuts in its pre-bankruptcy labor contracts with police officers and administrative workers, but it remains at loggerheads with the International Association of Firefighters and the International Brotherhood of Electrical Workers.

McManus’s ruling ought to show workers and municipalities that they need to negotiate more seriously to avoid bankruptcy, said James E. Spiotto, a partner at Chapman and Cutler LLP in Chicago.

“It’s a dangerous opportunity,” he said. “We have before us an opportunity where a lot of municipalities can solve some of their labor issues and unfunded pension obligation issues.”

He said the costs in municipal bankruptcy tend to be high for cities and their workers, but not for bondholders because revenues that have been pledged to debt service are protected under Chapter 9 and governments almost invariably find that they have to pay bondholders in full if they ever want to access the market again.

Vallejo has about $50 million of general fund debt, the vast majority in variable-rate demand obligations that are now held by Union Bank of California, its liquidity provider on the deals. It continues to make payments, but it has capped interest payments at 6%.

Still, the city has paid a steep price for the bankruptcy and its economic crisis in terms of reduced city services and loss of public employees it hoped to retain through the bankruptcy. Within three months of filing bankruptcy, it lost a fifth of its police officers to other jurisdictions and had to give up on investigating most property crimes. It also had to cut all funding for community groups, libraries, and other discretionary spending.

The benefit has been that just the threat that it would reject its union contracts injected new life into labor negotiations. The Vallejo Police Officers Association and the Confidential Administrative, Management and Professional employees union agreed to reductions in pay, deep cuts in health care payments for current and retired workers, increased staffing flexibility for city management, and minimal or no bankruptcy damage claims.

McManus’ memo shows he accepted the city’s contention that federal bankruptcy law preempts California law as the legal standard for rejection of the collective bargaining agreements. Union lawyers had argued that state labor laws govern collective bargaining agreements and protect public workers from unilateral contract changes even during bankruptcy.

McManus found that California had waived such protections for public workers when it allowed its municipalities to file for bankruptcy. He also said the U.S. Supreme Court’s 1984 ruling in case of the National Labor Relations Board v. Bildisco & Bildisco sets the standard Vallejo will have to meet to reject its labor contracts.

The city is represented by Orrick, Herrington & Sutcliffe and the unions are represented by Farella Braun + Martel LLP.

Bildisco requires a bankrupt debtor to show just three things before rejecting a labor agreement: that the agreement is burdensome, that the municipality tried to reach a voluntary settlement with workers, and that “the equities balance in favor of contract rejection,” McManus wrote. The final equities test is a fairness test that takes into account a host of factors including the public interest and the rights of other creditors.

Lawyers for the public employee unions say they’ll appeal if McManus actually finds that the facts show Vallejo has met the standard for rejection of the collective bargaining agreements. But outside experts were skeptical that city workers would find a more sympathetic ear with an appeals court.

“The judge is legally correct,” said Spiotto, who’s worked on municipal bankruptcy issues for more than three decades. “He made clear what is in the code and showed the distinction between Chapter 9 and Chapter 11 on how you go about rejecting union contracts.”

Kannel agreed that an appeal seemed unlikely to succeed.

The ruling is “a big deal, but frankly, I’m surprised that it became a big deal because the answer was pretty obvious,” he said. “Once the state Legislature has decided to allow Chapter 9 to be used by municipalities, then you’re playing by the Chapter 9 rules and the Chapter 9 rules are Bildisco.”

“The court clearly has authority to approve rejection of a contract, even more so in Chapter 9 than in Chapter 11,” which governs corporate bankruptcies, said Paul R. Glassman, an attorney with Greenberg Traurig LLP in Santa Monica. He represented cities that got caught up in Orange County’s bankruptcy in 1994.

McManus told the lawyers he either wanted to see evidence that they’d made progress in reaching a settlement at the March 23 conference or to be prepared to answer one last round of his questions before he rules whether the city has met the three-part standard for rejection of its union contracts.


Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.